To The Moon

By Tiger Trade Asset Management Research team

Recommend to Read:Panning for gold | Part I: 2022 major global assets performances review

Summary：

• US: Inflation? Recession?
• Eurozone: Inflation! Recession!
• China: Recovery? Recovery!

The two main investment focuses in 2022 revolve around the Feds tightening policy due to high inflation and industry chain reorganization focusing on security caused by the deglobalisation trend. In 2023, new investment logic and opportunities will form based on the combination of these two main focuses with the economic cycles and industrial development of major economies. Since the year 2000, globalization has led to a convergence of economic cycles across regions. But in the recent years, numerous factors such as deglobalisation, geopolitical conflicts and the pandemic have hindered the economic activities, policies and recovery process of countries. The synchronization of economic cycle has been severely impeded.

Data from Bloomberg，Chart by Tiger Trade

The pace in Europe and the US is relatively similar. Accomodative monetary policy after the pandemic helped with economy recovery but also caused inflation. Thus, after a slow economic growth in 2022, high inflation caused Europe and the US to fall into an overheating period before slipping into a stagflation. However, the Russo-Ukrainian conflict has caused more inflation and economic pressure on Europe than the US. That explains why the current inflation rate in Europe is higher. High inflation and negative real GDP growth means that the market believes the Eurozone is very likely to fall into recession in 2023. The economy in the United States is relatively more resilient compared to Eurozone. It's still possible for the US to have a soft landing next year. Although, looking at the economic cycle, the US is probably also heading into recession.

China runs a different cycle compared with Europe and the US. China has maintained a low CPI for the past two years. In 2022, the recovery process has been hampered mainly by the recurring pandemic. Even though China's monetary policy has eased, its economic cycle is fixed in the recession stage, and passed the overheating to stagflation cycle in Europe and the US. In 2023, due to the reopening policy, China will either move towards the recovery or the overheating phase.

Due to various economic conditions, geopolitical conflicts, rising protectionism etc, there is a difference in the current countries’ economic state. The economy outcome of last year will continue to affect and usher countries to move towards different directions in 2023.

1. US: Inflation? Recession?

Chart made by Tiger Trade

The Tiger Trade Asset Management Research team's built an exclusive US economic cycle model based on multiple indicators of economic growth and inflation expectations. The model shows that the US has entered stagflation since Q1 of 2022, and economic data consistently shows that the US is expected to enter a recession next year.

Although, it is also clear that the Fed's monetary policy will have a direct impact on the speed and extent of the US recession in terms of funding cost expectations.Powell mentioned, in his speech on November 30(th), that the Feds will definitely tone down after 4 consecutive 75bps rate hikes earlier this year. The slowdown pace of inflation and possible recession will then determine where the endpoint of Fed rate hikes will be and how long will they maintain at that point.

In other words, the trigger for the Fed to drop interest rates is either the CPI returns to the Fed's long-term inflation target or a significant recession risk occurs in the US economy next year.The downward trend of high inflation is certain, but it is difficult to return to 2% in a short period.

Data Source: Bloomberg, chart made by Tiger Trade

During the December FOMC meeting press conference, Powell repeatedly emphasized that the labor market remains tight and may cause core services inflation, excluding housing components, to fall very slowly. The Summary of Economic Projections (SEP) given by the Fed, likewise, reflects that Fed officials gradually revise inflation expectations upward.

As shown in the table below, the Fed expects that PCE inflation will remain above 3% at the end of next year, and core inflation will be higher. The CPI may return to about 2% - the average inflation target by 2025. Therefore, even if inflation continues to decline next year, it is still difficult to make the Fedsturn change directions and start decreasing interest rates.

Data Source: Fed SEP, chart made by Tiger Trade

US economic growth is still resilient. The problem lies in the past practices. Will the risk of recession next year, repeatedly mentioned by agencies in their 2023 outlook, cause the Fed to pivot? The Fed has not made a clear statement yet. Fed said the current priority is to tamp down inflation and then to balance the two long-term goals of price stability and full employment. That is to say, the Fed may turn to cut interest rates when economic data indicate a real recession (such as a significant upward movement in the unemployment rate and continued downward movement in real GDP). From the current economic data, the US economic growth is still strong: the number of people claiming unemployment benefits is still at the bottom; the bad debt rate of household leverage and business loans is at a low level. Clearly, the US economy is still a long way from recession.

Data Source: Bloomberg, chart made by Tiger Trade

Data Source: Bloomberg, chart made by Tiger Trade

Data Source: Bloomberg, chart made by Tiger Trade

However, the positive economic data does not mean that there is no worry about the US recession. The biggest recession risk for US next year comes from the business operations practices during the low-interest rate environment over the past decade. If companies are unable to adjust their operational methods to fit in a high-interest rate environment, sooner or later they will run into financial problems and lead to systemic risks.

The recent Musk stock pledge case is a typical example. The $13 billion debt that Musk borrowed to buy Twitter has already been written off by several banks. Morgan Stanley, who is in a death spiral with Musk, is considering swapping some of Musk's high-interest debt for lower-interest debt to ease the pressure on its interest payments.

Source: Reuters

Source: Bloomberg

Systemic risk often begins with the leveraging habit of enterprises during periods of accommodative monetary policy. The risk control departments of financial institutions also habitually underestimate the potential for large declines in the value of collateralized assets, ultimately triggering rapid deleveraging and systemic collapse. Such events could occur frequently in the next year, or even become the black swan that brings the US into recession. As of the end of November 2022, the recession forecast model of Bloomberg shows that the probability of a recession in the US in the next six months is 44%, and the probability of a recession in the next 12 months is 100%.

Data Source: Bloomberg, chart made by Tiger Trade

Base case scenario:

Based on the judgment that the Fed will still maintain high-interest rates and not pivot before economic data shows a true recession, the US will most likely remain in a stagflation period in 2023. The rise in US stocks will be determined by the expected difference in US economic growth relative to the rest of the world. For now, the US expectation looks better than Europe but not as good as China. In a scenario where the Fed rate hikes are confirmed to slow and nothing occurring out of the blue, overall US stock returns will be a bit better compared to this year. At the same time, we expect PCE to fall below 3.5% in the second half of next year. The Fed is very likely to raise its average inflation target to 3%, providing favorable conditions for shifting in time for the second half of the year when it is one step closer to recession.

Risks beyond the base case scenario:

The standard operational practices of companies in a low-interest-rate environment and the risk misjudgment of financial institutions may trigger systemic risk in a high-interest-rate environment. This scenario will lead to a rapid recession and liquidity crisis in the US, bringing a hard landing to clear risks. At the same time, Fed will also quickly cut interest rates so that post-crisis inflation expectations revive. The new scenario will bring a new rally for gold, commodities and resource stocks.

2. Eurozone: Inflation! Recession!

It is likely for Europe to enter recession at the end of this year or early next year due to the energy crisis.

The European economy has endured a huge shock this year: the energy crisis has greatly hampered normal production; inflation has eroded corporate profits and consumer incomes; and tightening monetary policy has dampened investment and consumption. In fact, in the second half of 2022, PMI of the Eurozone's manufacturing and services has been consistently below the key reading of 50%, reflecting that the European economy is contracting. At the same time, institutions expect real GDP growth in the Eurozone to fall into negative territory in the fourth quarter of 2022 on a year-over-year basis. This implies that the economy could be heading into a shallow recession amidst inflationary erosion.

Data Source: Bloomberg, chart made by Tiger Trade

Data Source: Bloomberg, chart made by Tiger Trade

European inflation is topping but not falling as fast as the US; Core CPI is likely to remain high

From a yoy perspective, the US CPI has fell back for some time and has turned around on a year-over-year basis. European inflation, nevertheless, is still at a high level and its fall-back process is slower than that of the US. However, as the Russo-Ukrainian conflict is coming to an end, the price shock of energy and food will also fall back quickly. Hence, we also see that energy and food prices drove inflation down in November.

Data Source: Bloomberg, chart made by Tiger Trade

In terms of core inflation excluding energy and food, the US inflation cycle has also fallen back ahead of the Eurozone. Core CPI in the US moved down in November year-over-year, while the Eurozone has yet to turn.

Data Source: Bloomberg, chart made by Tiger Trade

Services and wage growth typically climb slower than goods. These factors will limit the speed of core CPI retreat in the Eurozone. Wage growth in the euro zone was slower than inflation growth over the past year. High inflation will lead the workers to demand higher wages subsequently, thus making inflation maintain stickiness. But if the economy enters a recession, the recession will lead to higher unemployment and suppress wage increases, thus blocking the spiral of wage and inflation from rising further.

Data Source: Bloomberg, chart made by Tiger Trade

We forsee a fall in food and energy prices will probably drive the European inflation downwards when Russia- Ukraine conflict is further resolved. However, the lag in services and wage growth will keep core inflation resilient at high levels.

Interest rates are not high in absolute terms, but inflation is still under pressure. There is limited room for interest rate cuts.

Overall, inflation in the Eurozone is likely to be topping next year, but the rate of decline will probably be slow. If Europe moves into recession, even with relatively low absolute interest rates, high inflation will hinder the easing of monetary policy. The ECB will find it hard to step in by means of interest rate cuts. It is the same with the current swap market pricing, whose implied rate is expected to remain around 3.1% beyond the end of next year's rate hike.

Eurozone interest rate expectations implied by overnight swaps, Data Source: Bloomberg

Base case scenario:

We predict that the base case for the Eurozone next year is that energy and food prices move downward as the shock of the Russia-Ukraine conflict wanes. It will drive overall inflation to top out and fall back. But wage and service inflation limit the downward speed of overall inflation. Against this backdrop, even if Europe steps into a shallow recession in the first half of the year, high inflation will constrain the ECB from adopting an accommodative monetary policy. Benchmark interest rates will remain at peak for a longer period. The performance of European equities is likely to be worse than that of the United States.

Risks beyond the base case scenario:

• The deterioration of the Russo-Ukrainian conflict could lead to high inflation in the Eurozone and a longer-term substantial recession.
• ECB's easier-than-expected monetary policy leads to a wage-price spiral and hyperinflation.
• Europe's loose fiscal policy may increase the risk of government debt, raise market interest rates, and even generate a new round of European debt crisis.

3. China: Recovery? Recovery!

Pandemic and Recovery

"Pandemic" must be the key word for China's economy in 2022. Since the introduction of "New Ten Rules" for optimizing pandemic prevention, the speed and extent of the policy shift has exceeded expectations. Although the market still conducts policy rehearsals at the beginning of December, the policy direction is now quite clear.

• Optimizing pandemic prevention: On November 11, the State Council announced the new "20 articles" on optimization of pandemic prevention; on December 6, the State Council issued the "New Ten Rules"; on December 13. Officially ending the digital travel code services .
• Stabilizing economic growth: Since November, the three major real estate policies of "credit, bonds and equity" have been released one after another; on November 25, the central bank announced a 0.25% cut.
• Reinvigorating the economy: In early December, the Central Political Bureau meeting further increased the policy efforts to stabilize growth. These policies will promote economic operation and help achieve reasonable growth. The central economic meeting in mid- December explicitly mentioned the support for platform economy enterprises in leading development, creating employment and making a big difference in international competition.

Overall, the direction of policy stimulus is very clear on both the supply and demand side. The expectations for China's economic recovery in 2023 have grown stronger.

Data Source: Bloomberg, Chart made by Tiger Trade

Consumption and Domestic Demand

During the pandemic, resident savings have been increasing due to uncertainty about the future. From the end of 2019 to the end of 2022, the balance of savings deposits of urban and rural residents increased by nearly RMB 30 trillion, with new additions close to the sum of additions over the past 10 years. In contrast, people's consumption habits have become conservative and consumer confidence is more subdued. On December 14, the CPC Central Committee and the State Council issued the "Outline of the Strategic Plan for Expanding Domestic Demand (2022-2035)", which calls for the firm implementation of the strategy to expand domestic demand and develop a complete domestic demand system.

According to Bloomberg's consensus estimates, total retail sales of consumer goods are expected to grow by 4.9%, 8.7%, 5.4% and 4.8% year-on-year in the four quarters of 2023, which is much better than the growth in the same period of 2022.

Data Source: National Bureau of Statistics of China, Bloomberg, Chart made by Tiger Trade

(The actual data were used before 2022 Q4. After Q4, the consensus median from Bloomberg were adopted.)

Investment and Production

In 2022, the consumer demand side and the production investment on the supply side are both sluggish. For one thing, as of mid-December, the M2-M1 scissors differential continued to widen, and the amount of "dead money" is still increasing. The willingness to produce has not seen a significant increase for the time being. Even if the central bank money supply is sufficient, the social financing data doesn't improve.

Data Source: Wind, Chart made by Tiger Trade

On the other hand, the latest PMI in November continues to hover below the key reading of 50%; fixed asset investment continues to be sluggish year-on-year; and the willingness to expand production remains very low.

Data Source: Wind, Chart made by Tiger Trade510

Considering that there will be a significant wave of shocks after relaxing pandemic prevention, all aspects of production, logistics and sales will have an impact especially during the year end period and the Chinese Lunar New Year. According to the data observed in the US, Japan and Europe, the manufacturing PMI declined to various degrees in the first 2 quarters after the easing of pandemic prevention.

However, considering the weakening of the virus at this stage and China's special national realities, we believe that China will resume industrial production more quickly. It is expected that all production data will gradually improve by Q2 2023.

Data Source: Wind, Chart made by Tiger Trade

Trade and Export

Firstly, based on previous points, the world's major developed markets including the United States and Europe, are likely to get into recession next year. Affected by recession, the import demand in Europe and the United States, corresponding to China's export demand, may be greatly reduced. From historical data, the US financial crisis in 2008 and the Covid-19 pandemic in 2020, have caused a recession in the US economy, and at the same time had a considerable impact on China's net exports.

Data Source: Wind, Chart made by Tiger Trade

Secondly, a general trend of deglobalisation is brewing. Even though Sino-US relations seem to be easing, it is still difficult to see substantial improvement due to the fundamental conflict of interests. Meanwhile, the US has launched an "industrial chain repatriation" program. China has been actively engaging in trade negotiations with Europe and the Middle East. It is clear to see that since the US-China trade dispute in 2018, the year-on-year value of China's exports to the US has shown a negative correlation with the year-on-year value of exports to Saudi Arabia. The complexity of international relations will also suppress the demand for foreign trade to a certain extent.

Data Source: Wind, Chart made by Tiger Trade

Base case scenario:

The impact of the pandemic in China will soon be over, and economic growth will be the focus in 2023. From the perspective of the economic drivers, foreign exports are under pressure from external influences; investment and production will still be affected by the pandemic; the stimulation of domestic demand, especially consumption, will become the top priority for economic recovery.We believe that China has sufficient experience and abundant means to stimulate consumption. Hence we remain cautiously optimistic about the road to consumption recovery in 2023. On the premise of recovery, Hong Kong stocks and Chinese stocks are also expected to get back on track and repeat the market trend of 2017.

Risks beyond the base case scenario:

• The impact of the pandemic has been slow to fade, causing a delay in the recovery of domestic demand and consumption.
• Foreign trade is dragged by the possible recession or even hard landing in Europe and the United States.
• The emerging of new geopolitical conflict.